The Risk Now Is Not That The Federal Reserve Raises Rates But That It Doesn't

One of the lovely little predictions that we get from the efficient markets hypothesis is that markets are forward looking. This means, among other things, that information that everyone knows about what will happen is already in prices. Sure, everyone might be wrong about what is going to happen but then that would be new information, when they were shown to be, which would change prices. And so it is with the Federal Reserve and an interest rate rise. Everybody and their grandmother is near absolutely certain that rates will rise at the next meeting and so prices already reflect the impacts of such a rise.

The danger then to market stability is not that the Feds raise interest rates, but that they don't:

There now is little doubt among private economic forecasters that the Federal Reserve will raise short-term interest rates next week.

About 97% of business and academic economists surveyed by The Wall Street Journal in recent days predicted Fed officials will raise the benchmark federal-funds rate Wednesday. Just 3% said they expected officials would wait until next year to move rates up.

So, everyone is expecting that rate rise. Which means that it would be not having a rate rise which would be the new information and this change prices again:

Given that investors now consider a December interest rate rise a near-certainty, and markets have for the most part reacted calmly in the run-up, chances are good that there will be no meltdown. As fund managers say, “it’s in the price”.

Given that it's in the price already then, remarkably, the Fed doesn't actually have to raise rates at all. For the aim of raising the central bank determined interest rates is to change the market determined ones. But if market prices already reflect the future change in central bank ones then those don't need to change in order to gain the desired effect.

Until, of course, rates aren't raised on the day and market prices reverse to account for that new information. But there's a further level to there not being a rise:

Indeed, many analysts and fund managers argue that if the Fed refrained from increasing interest rates it could trigger a market meltdown, by revealing fears over the health of the US and global economy and damaging the Fed’s credibility after talking up the prospects of tighter monetary policy for months.

If the Fed doesn't raise rates then that is new information of course. But then would come the panicky asking of, well, what the heck is it that the Fed knows that we don't which prevented the rate rise? At which point there would be chaos in the markets.

What's amusing about this is that now that the Fed has been indicating that it's going to raise rates in December then, really, it has to raise rates in December. Because not to do so would cause the very market panic that everyone's trying to avoid.

Raising rates at some point is obviously the correct decision. I have a great deal of sympathy with the argument (Krugman being a prominent exponent) that a little later would be better, after we've seen what effect continued low rates have on encouraging discouraged workers back into the labor market, but given all the rhetoric so far on balance December probably is the right time.